Rationalizing Bubbles, Shaping a Legacy

Two speeches in two days. One on mortgage banking, the other on economic flexibility. It looks like Alan Greenspan has shifted into full-time legacy-shaping, arse-covering mode.

Four more months of this, and then it's over.

Largely responsible for the mess that will be left behind upon his departure in January (we call it a mess, but then of course we have to - others think of it as a two-decade long party that never has to stop), Mr. Greenspan seems to be calming nerves, defending his policies, and sounding warnings - all with increasing frequency in recent months.

The speeches of the last two days are fine examples of efforts to allay the fears of a rattled citizenry, demonstrate how he is still on top of things, and to let everyone know what they need to do in order to assure their continued economic well-being after he departs.

Monday is for Mortgages

In Monday's speech on mortgage banking, we learn that he is so on top of things that he just co-authored a new report! His first report in nearly ten years, we are told. Titled "Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four-Family Residences", this is a largely impenetrable work that does however yield the following conclusion.

Regardless of the precise mix of factors that explains the decline in interest rates, the associated run-up in housing values has left households with a substantial pool of available home equity. According to data recently developed by Jim Kennedy of the Federal Reserve Board staff, and me, discretionary extraction of home equity accounts for about four-fifths of the rise in home mortgage debt.

Instead of stopping to marvel at what he was instrumental in creating, that is, the nearly trillion dollars per year of home equity that Americans are "extracting" from their homes, he casually continues with an explanation of how the data was interpreted, how half of this money goes directly to consumer spending, and how this explains our country's abysmal savings rate. A more appropriate response to this finding would be:

Holy Sh**t! What have I done? People are using their homes like ATMs!

Further on there is a discussion of housing market froth (little bubbles, lots of them) in local markets (lots of local markets) and how there has been a marked increase in the turnover of second homes and investment property. This increase may be an indication of speculative activity, but it probably just needs to be studied.

We are then introduced to a novel concept - that housing market froth has "spilled over into mortgage markets". Well! Those homebuyers just can't seem to keep their froth to themselves - they're spilling it on the mortgage lenders! Maybe a better way of putting this would be that the Fed started a credit bubble that turned into a mortgage bubble that enabled a housing bubble that is now only sustainable through interest-only loans and other exotic mortgages.

This characterization, as excerpted from the speech, just doesn't give proper credit to the source of the credit:

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny.

So, just to be clear. Holding real interest rates below zero for years at a time and failing to regulate the banking industry while encouraging people to use ARMs - not froth-like. Homebuyers and mortgage lenders participating in a once-in-a-lifetime housing mania, desperate to buy and finance homes at astronomical prices - frothy.

Finally, we learn that we should all sleep well at night because loan-to-value ratios are just fine. Or, at least they are fine when looking at the 90 percent LTV mark combined with the last couple years of double-digit price appreciation.

In summary, it is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices.

But what about the marginal buyer who bought six months ago, surely not part of the "vast majority" cited, but still important. How about if prices decline at double-digit rates for a few years? How about a 40% drop in Southern California housing prices similar to what occurred about ten years ago after a far smaller run-up in prices? How much cushioning will there be then?

Tuesday is for Flexibility

In Tuesday’s speech on economic flexibility, after reviewing the impact of Adam Smith and John Maynard Keynes, we learn how 1980s deregulation loosed what Joseph Schumpeter termed "creative destruction" on an American public which had been conditioned to expect very little from their economy or its policymakers.

Deregulation, along with information technology, financial market creativity, reliance on market forces, and competition are the areas of "flexibility" that are considered critical to continued prosperity, according to the Fed Chairman.

Hmmm ... flexibility ... financial market creativity.

At least for the last few years, that's been the key area of flexibility, we postulate. And, reliance on market forces instead of government intervention - maybe not so much. Especially when it comes to exchange rates and long term interest rates.

About half way through re-reading the section on financial market flexibility, we had a feeling of deja vu and began to suspect that maybe we have postulated correctly. It seems that maybe "financial market flexibility" has an older brother named "productivity improvements", where the relationship can best be described by two series of events, the first series having started about ten years ago:

• Stock market bubble
• Technology driven productivity improvements
• Stock market crash

And, the second series having started about five years ago:

• Housing market bubble
• Financial market flexibility
• [End result of housing bubble]

So, the stock market is to housing market as productivity is to flexibility. An interesting theory, and perhaps a future graduate level economics final exam question.

It is as if the productivity miracle of the 1990s explained and justified the existence of the stock market bubble which everyone then sat around and watched burst. And, today, it is as if the new flexibility provided by asset-backed securities, collateral loan obligations, and credit default swaps explain and justify today's real estate prices. We don't know what the end result of the housing bubble will be, but it sure seems like there are a lot of people sitting around watching it.

Apparently it's all about the risk. And, how we have somehow, through innovation and technology (and with help from a real estate market that goes briskly in one direction - up), managed to disperse all of today's housing market credit risk to the point that it almost doesn't even exist anymore. Almost.

The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection.

These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago. After the bursting of the stock market bubble in 2000, unlike previous periods following large financial shocks, no major financial institution defaulted, and the economy held up far better than many had anticipated.

If we have attained a degree of flexibility that can mitigate most significant shocks--a proposition as yet not fully tested--the performance of the economy will be improved and the job of macroeconomic policymakers will be made much simpler.

Yes that's right - much of the system today is based on hedge funds selling credit default swaps (i.e., loan default insurance). This is the major support of today's financial market flexibility, and about the only thing that can sustain today's home prices given rising interest rates and current incomes of home buyers. Reading the multiple qualifiers and meager results sought in the concluding parapraph of the excerpt above, it is clear that the author is under whelmed.

The section on "too much stability" is one of the more intriguing parts of this speech. Mr. Greenspan has been talking about this a lot as he nears retirement - good to have all plausible explanations out there ahead of time just in case the whole thing comes tumbling down next February (recall that the crash of 1987 occurred only six weeks after the Fed Chair transitioned from Volcker to Greenspan).

It is as if he laments having been too successful at his job - that by providing too much stability he has created instability.

... history cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.

Therefore, because it is difficult to suppress growing market exuberance when the economic environment is perceived as more stable, a highly flexible system needs to be in place to rebalance an economy in which psychology and asset prices could change rapidly. Indeed, as I have pointed out in the past, policies to enhance economic flexibility need to be as integral a part of economic policy as are monetary and fiscal initiatives.

We can only conclude that should something go awry with the housing bubble, we will see things that we never dreamed of before - flexibility on a grand scale. Just think back to late 2000 when asset backed securities were little more than a twinkle in the eyes of Wall Street, struggling at the time to understand reversals in equity markets.

And lastly, the oft repeated "I did the right thing by not popping the stock market bubble" rationale - once again, for good measure. It doesn't really fit in with the flexibility theme of this speech, but maybe it just hadn't been stated publicly in the last week or so and there was fear of this truism fading from our collective memory. Clearly, after a year or so of questions about whether the stock market bubble had morphed into a housing bubble, the "no-popping policy" of the Fed warranted repeating. If people hear something repeated enough times, they tend to believe it, regardless of its merit.

Relying on policymakers to perceive when speculative asset bubbles have developed and then to implement timely policies to address successfully these misalignments in asset prices is simply not realistic. As the Federal Open Market Committee (FOMC) transcripts of the mid-1990s duly note, we at the Fed were uncomfortable with a stock market that appeared as early as 1996 to disconnect from its moorings.
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By the late 1990s, it appeared to us that very aggressive action would have been required to counteract the euphoria that developed in the wake of extraordinary gains in productivity growth spawned by technological change. In short, we would have needed to risk precipitating a significant recession, with unknown consequences. The alternative was to wait for the eventual exhaustion of the forces of boom. We concluded that the latter course was by far the safer. Whether that judgment continues to hold up through time has yet to be determined.

See, it just wasn't realistic to pop the stock market bubble - it's as simple as that. Better to wait for the boom to exhaust itself, then play the hero. Better to swoop in and save the day, taking no responsibility for creating any of the problems in the first place.

It is clear that "exhaustion" is and will continue to be the monetary policy prescription for the housing bubble - it is not clear, however, what can possibly be done to save the day.

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Six Months and Counting

[Still recovering ... much more slowly than we had hoped. A brief diversion today before resuming normal activities sometime in the next few days.]

Today marks exactly six months from the day that the very first post appeared on this blog. We thought it would be appropriate to take a quick look back at the last half-year to see how this all began and what it has turned into.

This blog started as a simple experiment to see if there was anything that we could write that anyone else would be interested in reading. For the last five years or so, having spent hours each day reading online news on subjects related to personal finance, financial markets, and macroeconomics, we often wondered if we had anything interesting to say, or if we should just be content to read.

If we were to commit some of our thoughts to the written word in a more formal, organized manner, who would read them?

Then along came blogs - truly a revolution in the dissemination of news and opinion. After reading what others were writing, and being sure to confine our commentary to our area of marginal competence, we dipped our toes in the water. It is really quite remarkable that personal publishing via blogs is not only available to everyone and easy to do, but it's free (or close to it). Anyone with a computer and an internet connection can do it.

We seem to have carved out a little niche here in the blogosphere - irreverent and sometimes funny commentary for a subject sorely lacking in both. Having attracted a small but growing number of regular readers who seem to enjoy what we do, we are not sure where exactly things will go from here. But, in the mean time it is fun to do and the feedback we've received is quite nice.

In the past six months, articles of ours have appeared at Financial Sense Online and as guest commentary at PrudentBear. Many other blogs, websites, and message boards have found posts on this blog to be informative, amusing, or some combination of the two and have linked to us.

Search engines seem to be taking some notice - for some reason MSN Search comes up with this blog for a surprising number of Greenspan queries. We wonder what people think when the name of this blog pops up in response to a very serious search request?


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We were mentioned briefly in an L.A. Times article a while back, but by far, the most interesting and humorous mention of this blog was in the Washington Post. This is surely an automated Technorati search - a feature which perhaps they should rethink, given what can show up.


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We don't know what the future holds, but we plan to continue doing this for the foreseeable future. We believe that the next six to eight months have the potential to be one of the most exciting times in financial history, and plan to be around to talk about it.

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Another Break

Surgery went off without a hitch yesterday - everything went well, but the recovery will take a few days, during which time it is difficult to think clearly or sit comfortably.

Look for the next post early next week - maybe sooner.

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Blinder and Kudlow on Gold

Yesterday, the Federal Reserve took another baby step toward safe and sane monetary policy by raising the overnight bank lending rate from 3.5 percent to 3.75 percent. The policy statement acknowledged the devastation caused by Hurricane Katrina, but indicated that accommodation would continue to be removed at a "measured" pace.

While noting that core inflation has been low, that underlying inflation is expected to be contained, and that longer-term inflation expectations remain contained, they acknowledged that higher energy prices have inflationary potential.

Whew!

That's a lot of talk about inflation - for a moment there it looked like they were going to tell us that we actually had some.

Gold as Kryptonite

It is not often that we tune into CNBC - it is best taken in small doses, abstinence is ideal. Yesterday, we did happen to catch a portion of Ron Insana's panel discussion after the Fed policy announcement. Former Fed vice chairman and devoted Greenspan worshipper Alan Blinder was one of the guests.

A chart of the historical relationship between real oil and real gold prices was shown. The chart clearly showed the decades long correlation between these two commodities and indicated in a not-so-subtle way that gold would be closer to $1000 than $500 if this relationship had not broken down over the last few years. Barry Ritholtz over at The Big Picture had this chart up the other day - apparently Ron showed this chart last Friday as well.

Hmmm... Perhaps Ron owns some of the yellow metal. Or, maybe he's just curious.

After a few words about commodities and inflation, Insana asked Blinder a long and tortured question about the Federal Reserve and gold. Here is the discussion that followed:

Blinder: So, I'm not sure what the question was. Are you asking should the Fed be talking about the price of gold?

Insana: Should it be looking at the price of gold as an inflation indicator. Yeah.

Blinder: No. I think it's time we outgrew gold. The numbers that you just cited show that gold's been a lousy investment, but that's kind of beside the point. It's also not a good indicator of the stance of monetary policy, the state of bank credit, a predictor of inflation, or anything like that.

Judging from this brief discussion, we conclude that gold must be like kryptonite to central bankers - we couldn't help but notice that at just the mention of gold, Blinder's multiple facial ticks, already apparent prior to the gold question, quickly intensified and stayed elevated during this exchange.

It was quite odd to listen to a Fed economist, with little control over any muscle on his face, dismiss gold. We wonder if any Chinese or Japanese central bankers were watching.

While we tend to agree that gold has been a lousy investment since 1980, we also acknowledge that it may not be relevant to monetary policy or bank credit. Moreover, we question how good a predictor of inflation it has been or will be - it seems so much depends on how inflation is measured.

However, there is one thing that we are sure that gold is useful in predicting. That one thing also happens to be the title of a catchy REM song from five or ten years ago ... the one thing that the gold price surely excels at predicting is - the end of the world as we know it.

Maybe the prognostication has already begun.

"Core" Commodity Prices

Meanwhile, over at the National Review Online, we find that Larry Kudlow has penned another interesting article. Normally, we get right at the business of mocking Larry's statistical sleight of hand, but we find ourselves caught off guard at the first line in his current offering:

"With gold knocking at the door of $470 an ounce, a degree of uncertainty has crept into the inflation outlook ..."

Respect for gold? Like CNBC, Kudlow dosage should be severely restricted, so we don't know if Larry has a long-standing respect or fascination with gold, but obviously it does not have the same Kryptonite-like effect on Wall Street economists as it has on central bankers.

After waving his magic wand to come up with a few benign statistics - surplus money creation of 1.5 percent and inflation measures of 1.8 and 2.1 percent - he starts making sense again:

"But gold remains a core indicator of future inflation, and the recent spike near $470 an ounce demands attention. Prior to this, gold had traded in a generally narrow range in the past nine months, with a high last Friday of $457.20 and a low of $411.10. The London afternoon fixing price had ranged from 6.3 percent above the nine-month average ($430.06) to 4.4 percent below it. That’s a fairly stable record."

So, gold is an indicator of future inflation? A "core" indicator? (Thankfully, not a "core" indicator of "core" inflation.) Larry seems to be quite interested and perplexed with the gold price action lately, as are many others in the financial media. Maybe "concerned" would be a better word.

He continues:

"Other real-time indicators also have reflected a non-inflationary monetary environment. Bond yields around 4.25 percent remain at four-decade lows. Spot commodity prices (that exclude energy and gold) have flattened out and stabilized over the past twenty months. The exchange value of the dollar has been gradually rising this year. Even the oil spike is abating. Sweet West Texas intermediate crude is trading around $65 a barrel, 7 percent off its August 30 peak. Unleaded gasoline has plummeted 25 percent."

We still don't know how long term yields, the "conundrum", having confused and confounded legions of analysts and commentators, can still be relied upon to predict future inflation. It seems that while there may be confusion about just about every other aspect of long term bond yields, the predictive value relative to inflation expectations is intact. Is this sound logic or wishful thinking?

And, finally, we get our first glimpse of the future of commodity price reporting. It's not stated here, but we see where it's going - if you take energy and gold out of commodity price reporting, you get the "core" rate of commodity price increases, which, not surprisingly are more apt to be ... benign.

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California Jobs

Last week, the California Employment Development Department released the August jobs data, which showed an unchanged unemployment rate of 5.2 percent and a total of 17,200 new jobs for the month. Press reports noted that job growth was steady and in some areas the unemployment rate had dipped below 5 percent.

Some press reports also included a cautionary paragraph or two about the potentially problematic relationship between a peaking real estate market and job creation in recent years - job creation that has been heavily dependent on home construction and the "wealth effect" of rising home prices. In a weekend article, the Los Angeles Times noted the following:

Analysts, however, are concerned that the state is vulnerable to another potential economic storm: an expected slowdown in the state's sizzling housing market.

Much of the state's recent job growth has stemmed from the real estate boom, in such fields as construction, mortgage lending, insurance and home sales. Strong consumer spending has been fueled by the so-called wealth effect of higher home prices, as homeowners have tapped refinancings and home equity loans to pay for new luxury automobiles and Caribbean cruises.

We often wonder what kind of jobs are being created in this state to support the kind of real estate prices that are being fetched. It is clear that low interest rates and "innovative" financing are a large factor in today's astronomical home prices, but just what kind of jobs are being created to provide the future stream of income that will enable homeowners to continue making mortgage payments in the years to come?

Last month, these sectors accounted for all of the net new jobs (i.e., gains and losses in other sectors offset each other - these sectors accounted for 17,600 new jobs while the total number of new jobs was 17,200, on a seasonally adjusted basis):

1. Trade, transportation, and utilities
2. Leisure and hospitality
3. Construction

Last month, as well as for the last few years, the dominant category within each of these sectors has been:

1. Retail trade
2. Food service
3. Home building

Which roughly translates to the creation of a whole lot of jobs for:

1. Wealth effect-enabled purchases of imported goods
2. Wealth effect-enabled dining out
3. Construction of new homes to create more wealth

But we already knew that ...

Today we take a look at job creation by sector for the state of California for the four years following the end of the last two recessions - that would be from February 1991 to February 2005 and from August 2001 to August 2005. All charts are year-over-year changes, so seasonal adjustments are not a factor.


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First, note that these are private non-farm payrolls only - no government or farm employment is included and it excludes the tiny, and mostly inconsequential sectors of Natural Resources and Mining, and Other Services.

The scale is the same for both charts to make absolute comparisons easy. There was greater job loss in the early nineties, and greater job gain in the last two years - cumulatively, for the two periods, there was a total net loss of 119,000 jobs from 1991 to 1995 and a total net gain of 211,000 from 2001 to 2005. While the magnitudes are different, the timing is similar for the losses and gains in the two charts - both show two years of net job loss, bottoming out roughly two years after the last quarter with negative GDP growth, followed by two years of net job gains.

The question we seek to answer is, "Compared to a decade ago, how has recent job growth positioned the California economy for the future?" We all know what happened to job growth between 1995 and 2000 - it is well off of these charts. What can we expect for the second half of the current decade?

A crucial difference between the two periods is that in the early nineties, the California real estate market had just peaked. This explains the loss of Construction jobs during this period. However, in the 2001-2005 period, Construction is the leading source of job growth after technology had peaked. Manufacturing job growth is abysmal for both periods, but at least in the early nineties, there was some improvement which then led to a brief resurgence in the late nineties.

In the 2001-2005 chart, the impact of the wealth effect can be clearly seen in the Trade, Transportation, and Utilities sector as well as in Leisure and Hospitality. Remember these two sectors are for the most part Retail Trade and Food Service - shopping and dining. It is clear from this chart how job growth in these sectors followed growth in Financial Activities and Construction a few years prior.

The Professional and Business Services jobs were largely employment agency jobs (temporary jobs) in 2001-2005, so there is not a lot to get excited about there. In stark contrast however, the period of 1991-1995 showed excellent growth in both Professional and Business Services jobs as well as in Information. This set the stage for tremendous growth in these areas in the latter half of the nineties. This is what most consider to be high-quality service jobs - the kind of jobs that these days are being outsourced to India.

When looking at job creation in 1991-1995 versus 2001-2005, it is hard not to notice how much healthier the job growth was a decade ago. The nascent technology boom is evident in the 1991-1995 chart and both housing and finance were bit players in job creation. When looking at the 2001-2005, it appears almost like a desperate attempt to keep things from really falling apart - first Financial Activities, then Construction, then wealth effect-enabled consumer spending.

The light blue bars on the 1991-1995 chart look promising, the light blue bars on the 2001-2005 chart do not.

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Snow's Reconstruction Plan

Through a highly placed Treasury Department source, we have obtained a confidential memo from Treasury Secretary John W. Snow to President George W. Bush in which Secretary Snow proposes a bold, yet somewhat unusual plan to finance the Gulf Coast reconstruction.


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Thank You Bryco!

Well, it looks like all the home equity lending risk management guidelines are working wonders. As you'll recall, five federal agencies issued these guidelines back in May. At the time we likened this guidance to fitting a patient suffering from back pains with a back brace, while a cancerous tumor was growing inside, impinging upon his spinal cord.

It looks like the patient isn't even wearing the back brace.

Here's the transcript from a TV commercial that we stumbled across this morning. Fortunately, thanks to DVR (Digital Video Recorder) technology, the only time we watch commercials is by accident - this was just such an accident, however we did learn something.

We don't know if what Bryco Funding is offering the public is typical of others in the industry - our sample size of one is probably too small, but here it is:

If you are backed up against the wall financially, and you own a home and have a mortgage, there is a simple easy way to get fast cash.

Even if you've been in your home for six months, one month, or a day, Bryco Funding can use a new appraised value to get you cash instantly.

Credit scores as low as 500, bankruptcies, or foreclosures are not a problem. You don't even need proof of income or past tax records.

Call Bryco Funding now to pre-qualify, there's no obligation and there are no charges or fees for pre-approval. And since Bryco Funding lends their own money, they can make instant decisions and approvals.And, they can wrap up your loan in as little as ten to 14 days.

Stop worrying and screening phone calls from nagging creditors. Help Bryco help you today with a quick-cash loan. Just call the toll-free number on the screen. Our number one goal is to say yes.

At Bryco Funding we believe in loans, not limitations.

Yes, things are much better now that five federal agencies have weighed in on home equity lending, and Bryco must have some very cooperative appraisers to work with. While not stated in their advertisement, we can reasonably conclude that the minimum requirements for a home equity loan from Bryco are a home with equity and a pulse.

You have to wonder if the grand plan is to forestall as long as possible the inevitable outcome of the housing bubble. At least in California, as long as home prices remain elevated, with all the equity in California homes, we could probably go on for at least another five years borrowing against our homes even if everyone lost their jobs.

With a median income of around $50,000 and say, $250,000 equity in your home, that's an easy five years living off your house with no other source of income.

Maybe someone does have a plan.

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